Not All Loans Are Good For You
Loans that either delay payments or make the borrower dependent on future interest rates should be avoided. These attributes make borrowers more dependent on unknown future circumstances: their ability to make bigger payments in the future or future interest rates.
Unfortunately, there are many kinds of loans with these attributes:
Adjustable-rate mortgages (ARMs) should be avoided because any spikes in the interest rates will result in the borrower paying more per month. There is no way to know what interest rates will be in the future, and non-finance professionals are not qualified to try to manage interest-rate risk. Yes, rates for adjustable-rate loans typically start out lower than fixed-rate loans, but the catch is an interest-rate risk. In effect, banks charge a slightly higher rate for fixed loans than they do for variable-rate loans because lending at a fixed rate makes them bear interest-rate risk instead of passing it on to the borrower.
You should also not take on a loan with a teaser rate or teaser payment. These loans have introductory periods with lesser payments before larger payments become due at a specified date in the future. These loans may seem harmless, but they encourage borrowers to put off paying their loans into the future. Many people take on these loans with the notion that their futures are guaranteed to be brighter and that making payments in the future will be easier than making them today.
Worse yet, some people use these temporarily low payments to borrow more than they would if they had borrowed using a fixed-payment loan. Financial planning is not about pushing responsibility into the future nor is it about risking default by living beyond your means. If you can't make payments now, don't take on the loan. You don't know the future. If you can't make payments today you don't know if you can make them tomorrow.
"Balloon" or "bullet" loans should be avoided. A balloon payment tends to come at the very end of a loan that has small monthly payments, and it involves a promise that you are going to pay a large amount of cash at the loan's termination. One common balloon payment loan is a 5/15 loan. The first number, five, refers to the maturity of the loan. The second number, 15, is the number of years the due payments would take to buy down the loan.
Since the scheduled payments would take 15 years to pay down the loan and the loan balance is due at maturity in 5 years, most of the balance of the loan is due all at once, in five years. Most borrowers do not have enough money to pay the majority of their loan all at once and are forced to find a loan at maturity to pay off their existing balance. This forced refinancing is very dangerous because it makes the borrower dependent on the interest rates that prevail five years in the future, at the maturity of the loan.
No one knows what they will be! What if banks aren't lending in five years?
An interest-only loan does not pay down the balance of a loan, so the amount that the borrower owes does not go down. At maturity of the loan, the borrower would somehow have to come up with the entire balance of the loan. This is worse than a partially paid balloon loan.
An even worse kind of loan is a negative-amortization loan, which has payments that do not even cover interest! This kind of loan increases the balance the borrower owes over time. This is terrible because it compounds more and more interest for the bank and grows a bigger payment that will eventually come due all at once!
Loans with long maturities should also be avoided. Loans with 30-year or 40-year maturities extend payments into an uncertain future and grow more interest for the bank. Your job could disappear in a year. Your profession could disappear in a few years. Your entire industry could disappear in a few decades. How could you possibly enter into a contract to make payments in 30 or 40 years? For most borrowers, a 40-year loan would mature into their retirement! This is silly.
Loans with prepayment penalties should be avoided. Prepayment penalties charge borrowers a percentage for early payment. These penalties punish you for trying to avoid future interest expenses by paying down your loan early. They also punish you for paying off your loan early in the event that you sell your home or refinance your mortgage.
If you wish to learn more about interest rates and how to calculate them, we suggest taking our course in finance!
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